A sophisticated Supplier sells “meat products” (yum) to a struggling manufacturer (in this case, of food). The manufacturer files a petition to commence a chapter 11 case. The manufacturer (and now debtor-in-possession or Debtor) wants Supplier to continue to supply. Supplier recognizes that it received $13 million in payments in the 90 days before the bankruptcy case, and knows that somewhere down the line, the debtor (or one of its successors) is likely to sue Supplier to avoid and recover the $13 million in payments as preferential transfers, in return for which Supplier will have a possibly nearly worthless claim for up to $13 million against the estate. Supplier is also aware that the Debtor may be a “melting ice cube” that will fail without paying new post-petition invoices (which is how the case discussed below unfolded).

What to do? Per a recent opinion in the United States Bankruptcy Court, District of Delaware, the supplier should consider forging ahead with selling to the Debtor. Supplier may get paid its post-petition administrative expense claim. And, who knows, maybe the Debtor will reorganize successfully, thus either reducing its incentive to pursue preference lawsuits or — by increasing the percentage distribution on unsecured claims — decreasing the loss for the creditor if it has to return transfers to the estate. In the Quantum Foods, LLC case discussed below, the court held that when the ice cube melts, and the now liquidating Debtor fails to pay its administrative claim to Supplier, the Supplier may off-set any preference liability to the full dollar amount of that unpaid administrative claim. Thus there can a substantial payoff to selling to the Debtor (in the form of a dollar-for-dollar reduction in preference liability) when Supplier does not get paid.

The Quantum View: Yes, You Can Setoff Preference Liability With an Unpaid Administrative Claim

In The Official Committee of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc., Bankruptcy Judge Kevin J. Carey ruled on a previously-unsettled interpretation of the Bankruptcy Code, holding that a Supplier can use post-petition goods and services to offset pre-petition preference liability.

In Quantum, the Official Committee of Unsecured Creditors filed an adversary proceeding to avoid and recover over $13 million in pre-petition transfers from the Debtor to the Supplier, Tyson Foods, as preferential transfers under section 547 of the Code. About two months after the bankruptcy petition was filed (as the ice cube was on full melt), Tyson moved the court to allow an administrative expense of $2.6 million from the Debtor’s estate for Tyson’s supply of meat products after the bankruptcy filing. The Committee objected, arguing that section 502(d) of the Code mandated that the dismissal of any claims Tyson may have had against the Debtor’s estate until and unless Tyson’s preference liability was paid in full.

In reaching the decision, Judge Carey addressed two key questions: (1) whether Tyson’s setoff claim was a more properly characterized as a post-petition new value defense because of its impact in decreasing preferential transfers that could be restored to the estate; and (2) whether section 502(d) of the Code bars allowance of a creditor’s administrative expense claim while a preferential transfer liability is outstanding.

Tyson’s Setoff as a Post-Petition New Value Defense to Preference Liability

First, Judge Carey had no doubt that Tyson’s claim was, in fact, setoff and not a phony post-petition new value defense. “New value” is a preference defense under section 547(c)(4) of the Code that reduces liability for preferential transfers where a creditor supplies goods or services to a debtor after the preferential transfer occurred. The court explained that under the authority of the Third Circuit, new value must be given during the pre-petition preference period, which means it necessarily involves only pre-petition activity.

The court found that the administrative claim posed by Tyson as an offset to preference liability could not be a new value defense and was not characterized as one by Tyson.

Okay, but is setoff valid under these circumstances? In bankruptcy cases, setoff is permissible only when the opposed obligations arose on the same side of the petition date. Because Tyson’s administrative expense claim arose from post-petition transfers, setoff would be permitted only the Committee’s preference action also arose post-petition. Judge Carey found that, while the transfers giving rise to a preference action clearly arise pre-petition, a “claim” (like that of the Committee against Tyson) is defined as a “right to payment” and a “preference right to payment . . . necessarily arises only post-petition[.]”Therefore, the administrative expense and preference claims both arose on the same side of the petition date and setoff is permissible.

Does Section 502(d) of the Code Bar Allowance of Administrative Expense Claims While Preference Exposure is Outstanding?

Second, section 502(d) of the Bankruptcy Code disallows any claim of a transferee who is liable for a preference until after the transferee turns over the full preference amount to the estate. Section 502(d) creates incentives for creditors to resolve preferential liability – if they want distributions on their claims. The Committee argued that section 502(d) prohibits the court from setting off Tyson’s administrative expense claim (in effect treating the administrative expense claim as allowed) against potential preference liability.

Section 502(d) provides that in many cases, the court:

shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 of this title.

Preferences are avoidable under section 547 and are recoverable under 550 – both sections are listed in section 502(d). Judge Carey noted that, by contrast, administrative claims arise under section 503 of the Bankruptcy Code, which is not listed in section 502(d). Upon a review of case law, the court concluded that “administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d).” The court also expressed concern for debtors’ reorganization efforts if trade vendors would fear that a preference action may restrict payment of their post-petition administrative claims.